Challenge

A defined benefit plan sponsor was concerned with how potential changes in asset returns and interest rates could affect future funding requirements and accounting results. The effect of these risks on balance sheet volatility and contribution requirements has drawn more focus by the sponsor due to the new norm of volatile economic conditions. At the time of the analysis, their plan was well-funded and closed to new entrants, but active participants were still accruing benefits (soft frozen). Contribution requirements under the Pension Protection Act (PPA) and subsequent law changes are based on a plan’s funded status in combination with the cost of annual benefit accruals. Due to the funded status of the plan, there were no required contributions for the past several years, but the plan sponsor had been making infrequent discretionary contributions based on availability of cash. Asset returns were largely sufficient to fund benefit accruals during this time frame. However, due to declines in funded status as the cost of benefit accruals outpaced the contributions, as well as a recent year with negative asset returns, the sponsor requested the Milliman team project future funding requirements and the impact a discretionary contribution in the current year would have on future years’ requirements. The sponsor was also interested in the potential size of future contributions over the near term with respect to their budget. If the potential contributions were larger than their budget would allow, the retirement committee would begin discussions with respect to a hard freeze and the impact on potential costs of replacement plans, such as a 401(k).

Approach

The Milliman team proposed a forecast analysis with multiple deterministic scenarios to model the contribution requirements over the next five years. The scenarios included scenarios with high asset returns, negative asset returns, and scenarios between these. These scenarios illustrated a range of possible outcomes that would help the sponsor make important risk management decisions. Depending on the range of results, the sponsor would have further discussions with the Milliman team about whether additional deterministic scenarios should be modeled or stochastic modeling was warranted to assist in making their decision.

The plan follows a calendar plan year, and the forecasts were prepared at mid-year. The specific scenarios accounted for actual return to date and asset returns for the remainder of the year as follows:

1. 15% asset appreciation
2. Asset return according to expected returns
3. 0% asset return
4. 15% asset decline

The asset returns for the subsequent years were assumed to achieve the plan’s current expected return on asset assumption.

The plan’s liabilities were modeled using three different interest rate scenarios: increasing rates by 100 basis points, no change to rates, and decreasing rates by 100 basis points.

To illustrate the impact a current year contribution would have on the future years’ results, these same scenarios were repeated, including the cash contribution.

The Milliman team prepared the scenarios and a set of exhibits to present to the plan sponsor. The range of outcomes varied from the sponsor having zero required contributions over the next five years to scenarios requiring large contributions in excess of normal cost as early as the following year. This wide range of outcomes illustrated to the sponsor that although their plan was currently well-funded and had no required contributions, they still had significant exposure to market risks and the associated effects on funding requirements. The exhibits below are samples of what was presented to the sponsor.

Outcome

The forecast resulted in the following decisions by the plan sponsor:

• The forecasted impact of a contribution in the current year on future years’ requirements and cash presently available resulted in the decision to make a discretionary contribution to the plan in the current year to help defer contribution requirements in future years.
• The projected level of cash contributions resulted in a deferral of hard freeze discussions, as the projected costs of the plan were still manageable based on the plan sponsor’s budget.
• The risks inherent in the volatility of market movements resulted in the sponsor considering whether investment allocation changes should be made in light of market volatility and the current equity exposure. As a result of the projection analysis, the plan sponsor requested that the Milliman team work with the investment consultant to prepare an updated asset-liability management (ALM) study.

The sponsor considered these forecasting analyses to be a success and expects to refresh the analyses regularly in the future to monitor their exposure to market risks.